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I owe readers a mea culpa on Europe as of late. The LTRO far surpassed my expectations of helping stabilize the region. But my position hasn’t changed much. I still think the European debt crisis ultimately comes down to a question of budget sustainability and the road to sustainability runs through growth. As I’ve shown in the past, Italy and many other peripheral nations have to grow substantially if they’re going to reduce budgets meaningfully without fiscal aid. That idea is completely at odds with the austerity that is being imposed. So, my thinking in a nut shell is that this crisis will flare up again when investors realize that the ECB’s funding programs are merely kicking the can. But so far, I’ve been wrong and the mantra “don’t fight the ECB” appears to be the strategy of choice….

Further supporting this thinking is the continuing balance sheet recession in the region. Richard Koo’s latest note discusses this and shows a frightening trend where loan demand is now contracting again:

“Eurozone loan demand has resumed contracting

The ECB report also points to a continued and marked decline in eurozone loan demand stretching back to 2011 Q3. One reason for sluggish demand is that economic weakness is prompting businesses to put off capital investment.

Eurozone loan demand contracted sharply in 2008 as regional housing bubbles collapsed, and the situation grew worse following the collapse of Lehman Brothers. Later the declines moderated, and by 2010 H2 demand was growing again, albeit at a modest pace, and was helping to fuel a eurozone recovery (Figure 3).”

“The sharp renewed drop in loan demand is a sign that the eurozone economy is entering a double dip and is once again in a balance sheet recession. That this is happening at a time when euro interest rates are at all-time lows highlights the severity of the crisis.”

Something doesn’t add up here. They can’t impose austerity, suffer a balance sheet recession and grow their way out of the budget mess. I could be wrong, but this analysis tells me that we haven’t seen the last of the Eurozone debt crisis.